Recent headlines tell the story: Interest Rate Rise Stuns Business in the UK"Š "Japan Slips into Recession"Š "Dow Industrials Plunge as Asia Keeps Falling." Today's equity markets are characterized by volatility and uncertainty - a situation that shows no signs of abating soon.
Volatility has always been a challenging part of global investing. But since the start of the Asian crisis 11 months ago, keeping one's head above water has been especially tricky. As we've seen, volatile markets can quickly make or break portfolio performance. Thus many equity investors may be asking themselves, "How do I keep from drowning in the second half of 1998?"
We recommend the same strategy for our international portfolios that worked in the first half of the year: overweight Europe and underweight Asia. According to our quantitative models, European markets have the strongest projected earnings growth. This should come as no surprise, since these economies continue to grow, albeit slowly, and have positive monetary, inflationary and fiscal environments. European currency markets are also stable. EMU is the driving force in this investment climate. On the other hand, Asian markets remain in turmoil. Their economies are contracting, the currency markets are unstable and the fiscal, monetary and political environments are unsettled.
The European markets we prefer are Austria, Belgium, the Netherlands and Norway. These countries exhibit the strongest earnings growth with the most favorable valuations. Germany, Finland, Ireland, Italy and Spain, while not quite as attractive, still have strong projected earnings growth. We continue to focus on restructuring companies in Europe, particularly in the auto and financial sectors. Financial stocks are also attractive due to the positive interest-rate environment.
We underweight Japan significantly, where extremely low interest rates have failed to stimulate the economy. (The Japanese economy appears to transcend simple term-structure manipulation.) This in turn has hindered corporate profits; our research suggests continued weakness in earnings momentum. Although valuations have recently dropped, they are not yet favorable. If an investor must own Japanese stocks, exporters - who depend less on the local economy - are the most attractive option since the depreciating yen is boosting their earnings. A caveat: Investors must be sensitive to where Japanese exports are shipped, since nearly half are destined for Asian countries where import levels may well continue to fall.
In the UK, the situation is reversed. The UK has a strong economy, but this has led the central bank to raise short-term rates higher than long-term rates, creating an inverted yield curve that has persisted for nine months. The higher rates are stifling corporate profitability, prompting us to slightly underweight UK stocks.
While the Asian Pacific markets exhibit the most favorable valuations, they still show the potential for declining earnings momentum, suggesting that these markets will become even cheaper. In Hong Kong, we would avoid the property sector - the market's most prominent group of stocks - which is being crushed by the high interest rates intended to stabilise the currency market.
Mary Ann C Bartels is an international portfolio manager at Batterymarch Financial Management in Boston"